IMF warns about Canadian debt, house prices

The Canadian government may need to act soon to halt the buildup of household debt, according to the International Monetary Fund.

The Washington-based IMF issued the words of caution in its latest regional outlook for the Western Hemisphere.

“Developments on the housing front require increased vigilance and consideration may need to be given to additional prudential measures to prevent a further building in household debt,” said the report.

Finance Minister Jim Flaherty already took some initial measures recently to slow mortgage borrowing, including reduction of the maximum amortization period to 30 years from 35 years.

Julie Dickson, superintendent of Financial Institutions (OSFI), recently also said her office is “stepping in to increase the monitoring” of home loans and lines of credit secured by real estate.

TD Economics recently noted in an economic report that the household debt-to-income ratio had reached 147% in the second quarter of 2011. The report explained a ratio of 138% to 142% is considered “appropriate.”

But the trouble might only be starting. TD Economics warned the debt-to-income ratio would rise to 150% by the end of 2012, then 151% by 2013. House prices have also now risen to concerning levels in some provinces, according to the report.

“On the domestic front, consumption might moderate more than expected from a large retrenchment in highly indebted households amid concerns of a drop in house price,” said the IMF. “The latter are estimated to be above levels dictated by economic fundamentals in some key provinces.”

The economy has remained stronger in Canada than elsewhere around the world, and improved global financial conditions could bolster confidence and thus spur more domestic demand, according to the report.

The IMF predicted a small rate cut is on the way, as well as no monetary stimulus through most of 2013.

Now, there is about to be a high-profile challenge of how mortgage penalties are calculated.

CIBC Mortgages Inc., a subsidiary of CIBC bank, has just been named the subject of a pending class action lawsuit.

The intended suit claims that CIBC improperly calculated penalties for customers who broke their mortgages from 2005 to date.

The claim alleges that:

“CIBC applied terms and conditions to certain mortgage contracts to allow it unfettered discretion for calculation of mortgage prepayment penalties.”

“…the quantification of prepayment penalties applied by CIBC are in breach of the mortgage contracts.”

“Starting in 2005, CIBC started using language in its standard charge terms that was extremely vague regarding how its prepayment penalties would be calculated,” says Kieran Bridge, lead counsel on the case, in partnership with Siskinds LLP.

“That language, in legal terms, is called unenforceable. The net result is that they cannot collect penalties with a clause like that.”

(If you’re interested, you can see some the penalty language CIBC Mortgages has used here—on page 13)

“Even if [part of the language] is enforceable,” says Bridge, the penalties should be “capped at three months interest.”

In addition to the above, the suit claims that CIBC charges the future value of monies owed in its interest rate differential calculation, whereas it should “adjust for present value,” asserts Bridge. “They ‘present-value’ all of their own assets and liabilities. Any actuary or accountant will tell you, you have to present value or you’re not talking about actual value received.”

Bridge says the lawsuit applies to most CIBC mortgages, including many of those originated in CIBC branches and through its related entities, such as FirstLine Mortgages and President’s Choice Financial.

CIBC Mortgages Inc. is one of the largest residential lenders in the country. Bridge estimates it has about 500,000 mortgages on the books, of which 5-10%—25,000 to 50,000 people—prepay every year. (We’re unable to confirm those stats.)

In terms of value, Bridge estimates this case is worth “into the tens of millions (of dollars).” These types of cases are usually settled out of court, however, and don’t usually make it to full trial.

He adds that there is plenty of precedent with respect to mortgage prepayment contracts and “uncertain contract provisions.”

“You don’t start a class action lightly,” states Bridge, adding that his firm has “literally spent hundreds of hours” researching this case before filing it. (Funny enough, we noticed a Siskinds lawyer collecting evidence on Ellen Roseman’s blog back in July.)

Bridge is not a rookie in class actions. He says he brought another prepayment-related class action against RBC where the class members were “paid 100 cents on the dollar” for their claims, plus legal fees.

“That was a very favourable settlement. It’s about the best you could possibly do.” (Although, that case had a very different fact pattern than this one.)

This particular class action all started with a single parent in B.C. whose marriage ended. That individual had to sell the family home and was stuck with a $47,000 interest rate differential penalty from CIBC.

Bridge has reviewed other banks’ practices and hasn’t yet found other lenders that are calculating IRD penalties improperly.

Our take: Mortgage penalty language is notoriously cryptic at the Big 6 banks. It would be interesting to see if a court ruled that CIBC is calculating its IRD penalties in a materially different way than its peers. One thing is for certain, few banks go out of their way to make penalty calculations intuitive. Maybe this lawsuit will change their thinking.

(Incidentally, RBC is one of the best big banks when it comes to IRD disclosure. They outline the formula they use, try to explain it and base their penalty calculations on present value, according to sources at the bank.)

Note: As a reminder, it has not been established at this point that CIBC has done anything wrong with respect to how it calculates mortgage penalties. Also, the defendant in this case is CIBC Mortgages Inc., not CIBC. “CIBC” is used in a standalone capacity above only as an abbreviation.

Borrowing: 10 things you need to know

Canadians love credit cards but the interest rate charges are high.

You’re in the driver’s seat when it comes to borrowing money. You don’t need to book an appointment with your bank manager to ask for a loan anymore. Credit is easily available, as long as you have a good credit history, and lenders are anxious to get your business.

My advice is to shop around as carefully as you shop around for the stuff you buy on credit, such as cars, furniture and home renovations.

But before starting to compare loan rates and features, here are 10 things you should know about borrowing.

1. Your credit history is important

To know how good you look to potential lenders, check your credit report at Canada’s two major credit bureaus, Equifax and Transunion. A credit report is a snapshot of your credit history. It shows how quickly you pay your bills and how often you’ve had collection issues. It might even show you’ve been a victim of fraud or confused with another person. While you have the right to see your credit report, you can get a copy for free only if you send a written request with two pieces of ID. Online requests are faster, but will cost you money.

2. Your credit score is important to lenders

A credit score is not the same as a credit history. You’ll pay about $25 to get copy of your credit score by ordering it online from the credit bureaus. It’s based on a mathematical formula that considers your payment history and other factors, such as how much of your credit limit you have used. The score is a three-digit number, ranging from 300 (low) to 900 (high). The higher the better? There’s a great guide to understanding your credit report and credit score at the Financial Consumer Agency of Canada.

3. Make sure the information is accurate

Make sure the information in your credit report is correct and up to date. If it’s not, talk to the credit bureau. Remember, the credit bureau has to contact the credit granter (such as a bank or a cell phone company) to see if the information is incorrect. To avoid delays, you can also contact the credit granter and ask it to follow up with the credit bureau. Once an error is confirmed, the credit bureau has 30 days to correct your credit report (except in Alberta, where it’s 90 days). If the credit granter refuses to fix the error, you can submit a brief statement to the credit bureau, saying the information is in dispute. This will be added to your credit report.

4. You can improve your credit score

To polish your image as a borrower and raise your credit score, you should always pay your bills on time. If you can’t do this, pay at least the required minimum amount a few days before the due date. Try to keep your balance well below the credit limit on your credit card or line of credit. Finally, you should be careful about making a lot of credit applications at once. Your credit score suffers if too many potential lenders ask about your credit in too short a time. (It looks as if you’re desperate.)

5. You need to build up a credit history

Your credit score will be low if you don’t have a history of borrowing money and paying it back. You can build up a credit history by applying for a credit card and using it. Once there’s activity, the card issuer will tell the credit bureaus about your outstanding balance and your record of making payments on time. You may be asked to get a secured credit card, which means you have to deposit a sum of money with the card issuer. This reduces the risk if you default on your payments. Check out information about secured credit cards and a comparison of the rates and features. It’s easier to get a loan when someone co-signs with you. But if you can’t repay, the other person is on the hook.

6. You may need a co-signer

If you have a limited or poor credit history, you will be seen as a high-risk borrower. You may not be able to get credit unless you find someone with a high credit score to sign the loan with you. Lenders know a co-signer cuts the risk, since the other person has to make all the remaining payments if you stop. You’re asking for a big favour when getting friends or family to co-sign a loan. So, you should write a contract setting out the payment schedule. This won’t hold up in court if you default, but it makes the relationship more professional.

7. Be careful with a personal line of credit

A line of credit often has a lower interest rate than a loan. It’s certainly more flexible. Once you’re approved for a certain credit limit, you can take out as much as you want and pay back only a required minimum amount each month. But remember you’re making interest-only payments, so you can pay the monthly minimum and never make any progress on trimming your debt. Remember, too, that a line of credit has a floating rate that can go up. If you prefer fixed rates, stick to a conventional loan.

8. Secured or unsecured line of credit?

Financial institutions love lines of credit. They know it’s hard to resist temptation when you’re handed a large amount of potential spending power. A line of credit backed by your assets, such as investments or a principal residence, usually has a lower rate than an unsecured line of credit. Both are based on the bank’s prime rate, such as prime plus 1 per cent or prime plus 3 per cent. You can save money if you get a line of credit secured by your house at the same time you apply for a mortgage or refinance an existing mortgage. Always try to pay more than the minimum amount so that you’re not spinning on a treadmill of debt.

9. Credit cards are a costly way to borrow

Most standard credit cards have annual interest rates of 18 to 20 per cent. And you’ll pay 25 per cent or more if you miss making a couple of minimum payments in a year. If you carry a balance on your credit card from month to month, you will lose the grace period of 20 to 25 days on new purchases. Cash advances on a credit card are also costly, since there’s no grace period. You’ll pay interest from day one and a fee for cash advances as well. So, use the credit card as a convenient payment method, but look for low-cost credit elsewhere.

10. Avoid payday loans

A payday loan is one that you promise to pay back from your next pay cheque, usually in two weeks or less. These loans are offered by privately owned payday loan companies and cheque cashing outlets, not by the big banks. Lenders ask for proof you’re over 18, with a permanent address, regular income and active bank account. To be sure you repay, they ask you to write a post-dated cheque or authorize a direct withdrawal from your account. Payday loans are expensive because of all the fees that may be charged. On a $300 loan for two weeks, you can pay $50 in fees. That’s equivalent to a 435 per cent annual interest rate, according to the FCAC.